Aug
15
2023
Beginners Guide to KYC

What Is Know Your Customer (KYC) for Financial Institutions?

By | Growing Wealth, invest, Investing | Comments Off on What Is Know Your Customer (KYC) for Financial Institutions?

There are banking regulations in place that are known as KYC. The definition of KYC is “know your customer,” and these rules provide guidelines for financial institutions to know more about their customers.

This isn’t just a matter of curiosity but of national security and crime prevention. Banks need to protect themselves from unwittingly participating in illicit activities.

If a criminal uses a bank for illicit purposes, such as money laundering money, the financial institution could be held accountable. It’s the bank’s responsibility to always know who their customers are. That way, they can help avoid being involved in criminal activity.

KYC plays an important role in financial institutions maintaining accurate information about their clients. KYC procedures and anti-money laundering (AML) laws can work together to minimize risk. Read on to learn more about know your customer regulations.

3 Components of KYC

There are three main parts of a KYC compliance framework: customer identification, customer due diligence, and enhanced due diligence. Each phase of the process of this kind of financial regulation gets more intensive according to the estimated risk that the potential client might pose.

Customer Identification Program (CIP)

The first of the three main KYC requirements is to identify a customer. (Incidentally, some people refer to KYC as know your client vs. know your customer.)

Organizations must verify that a potential customer’s ID is valid, real, and doesn’t contain any inconsistencies. The person must also not be on any Office of Foreign Assets Control (OFAC) sanctions lists.

An organization also needs to know if their prospective customer is “politically exposed.” A politically exposed person (PEP), such as a public figure, is thought to be more susceptible to corruption than the average individual, and is therefore considered high-risk, requiring special attention.

As part of their AML/KYC compliance program, all financial institutions are required to keep records of their Customer Identification Program (CIP) as mandated by the Financial Crimes Enforcement Network (FinCEN).

FinCEN works under the guidance of the department of Treasury and is charged with guarding the financial system against illicit activity and money laundering.

The following information will satisfy the minimum KYC requirements for a Customer Identification Program:

•   Customer name (or name of business)

•   Address

•   Date of birth (not required for businesses)

•   Identification number

For individuals, the customer’s residential address must be validated. US Postal Office boxes are not accepted. Individuals with no physical residential address can use an Army Post Office box (APO), Fleet Post Office Box (FPO), or the residential or business street address of their next of kin.

For business banking customers, the address provided for know your customer laws can be the principal place of business, a local office, or another physical location utilized by the business.

The ID number for most individuals will be their social security number or Taxpayer Identification Number (TIN).

For business entities, the number will usually be their Employer Identification number (EIN). Foreign businesses without ID numbers can be verified by alternative government-issued documents.

Recommended: Opening a Bank Account While Living in a Foreign Country

Customer Due Diligence (CDD)

Due diligence includes:

•   Collecting all relevant information on a customer from trusted sources

•   Determining what the customer will be using financial services for

•   Maintaining ongoing surveillance of the situation to further verify that customer activity remains in line with recorded customer information.

The goal of this phase of the know your customer process is to assess the risks a potential customer might pose and assign them to one of three categories — low-, medium-, or high-risk.

Several variables — including the customer’s expected cash transactions, the type of business, source of income, and location — will help determine the customer’s risk level.

Other categories for assessing risk include the customer’s business industry, whether they use a foreign or domestic account, and their past financial history. The customer is also screened against politically exposed persons (PEP) and Office of Foreign Assets Control’s (OFAC) sanctions lists.

Enhanced Due Diligence (EDD)

Enhanced due diligence (EDD) involves increased monitoring of customers deemed to be high-risk. This may include customers from high-risk third countries, those with political exposure, or those that have existing relationships with financial competitors.

Conducting enhanced due diligence on high-risk business entities requires identifying all beneficiaries of those entities when they open an account. Customers that are legal entities are those that have had legal documentation filed with a Secretary of State or other state office, and include:

•   Limited liability companies (LLC)

•   Corporations

•   Business trusts

•   General partnerships

•   Limited partnerships

•   Any other entity created via filing with a state office or formed under the laws of a jurisdiction outside of the US

On May 11, 2018, a new AML/KYC requirement came into effect. This change to KYC laws states that all banking and non-banking firms subject to the Bank Secrecy Act (BSA) must verify the identity of beneficiaries of legal entity customers when they open an account.

Firms must also develop risk profiles and continually monitor these customers. This must be done regardless of what risk category the customer falls into.

Due diligence is an ongoing process and requires financial institutions to constantly update customer profiles and monitor account activity.

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5 Key Steps Involved in Know Your Customer?

There are five main steps of complying with the know your customer rule, which is part of how banks are regulated. These include:

1. Customer Identification Program (CIP)

As mentioned above, the first step is to ensure that a prospective client’s ID is valid, real, and consistent. The address and other details must be checked. The applicant must be screened to be sure they are not on any OFAC sanctions list and their PEP status must be investigated.

2. Customer Due Diligence (CDD)

The next step of due diligence involves researching and vetting the customer’s intentions regarding the financial services they are seeking.

3. Enhanced Due Diligence (EDD)

Further scrutiny may determine that some applicants are considered risky. If the customer is deemed high-risk, additional ongoing screening is required to make sure activity doesn’t cross any lines.

4. Account Opening

If verification is successful and a client is eligible, the customer can open a bank account, with some clients requiring closer monitoring than others.

5. Annual Review

Once an account is opened, the institution will conduct an annual review of their activity. The higher the risk category a customer falls into, the more often their activities will be reviewed.

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4 Key Elements of a KYC Policy?

KYC compliance involves four key elements. When gathering KYC information, organizations must:

1. Identify Their Customers

In this step, the financial institution will gather information about the customer’s identity.

2. Verify That the Customer’s ID Is True and Valid

The identification documents will be checked against independent sources to make sure identity theft isn’t occurring

3. Understand Their Customer’s Source of Funding and Activities

In this step, a review of the customer’s activities and background can shed light on how likely it is that the client would do reputational damage or could commit crimes that involve money laundering or the financing of terrorism.

4. Monitor the Activities of Their Customers

Monitoring of customer activities is an ongoing process, particularly for high-risk clients. Most firms review clients based on their level of risk.

Low-risk clients might only be reviewed once every two or three years, moderate-risk clients every one to two years, while high-risk clients tend to be reviewed once a year or even once every six months.

Recommended: Guide to Keeping Your Bank Account Safe Online

Why Does KYC Matter?

KYC procedures matter because they are an important screening step. Their implementation can help verify customers and assess and minimize risk.

The KYC process provides guardrails and can help protect against such crimes as money laundering, terrorism funding, and other illegal activities.

Is KYC Successful?

KYC programs are seen as improving a financial institution’s reputation and integrity, though it can add a layer to a prospective client’s application process and banking life.

As the banking landscape evolves quickly with technological advances, banks are finding new ways to track customers and comply with protective KYC and other guidelines. For instance, artificial intelligence (AI) may be able to perform some of these functions.

AML vs KYC

KYC and AML are both ways that financial institutions comply with regulations designed to inhibit terrorism financing and money laundering.

•   AML is the more general practice of an institution seeking to identify and stop such activity.

•   KYC is one aspect of AML, focusing on customer identification and verification.

AML and KYC Similarities AML and KYC Differences
Designed to inhibit money laundering, including terrorism financing Focuses on customer identification
Both are implemented by financial institutions to comply with government guidelines KYC represents one aspect of larger AML procedures

The Takeaway

KYC, or know your customer, is a regulation that helps financial institutions prevent fraud by their customers. KYC involves constant check-ups and ongoing measures to ensure customer information and account profiles are kept up-to-date.

Wherever you decide to bank, know that teams are likely to be at work, ensuring compliance with KYC regulations.

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FAQ

What is a KYC procedure in banking?

KYC procedures in banking are regulations that involve a financial institution verifying potential clients’ identities and backgrounds and monitoring their activity if they become customers. This can be a part of the bank ensuring that it’s not being used in criminal activity such as money laundering.

Do all banks require KYC?

Yes. FinCen, or the US Financial Crimes Enforcement Network, requires financial institutions and their customers to adhere to KYC regulations.

Why is KYC mandatory in banks?

KYC is an important measure as banks work to know their customers and make sure accounts are not being used for illegal purposes. KYC regulations are one way that the government seeks to prevent money laundering and terrorism financing.

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Aug
14
2023
Why Would a Company Stop Paying Dividends?

Why Would a Company Cut Its Dividends?

By | Growing Wealth, invest, Investing | Comments Off on Why Would a Company Cut Its Dividends?

When companies reduce the dividends they pay investors, or stop paying them altogether, it can mean different things. Sometimes it’s a result of lower earnings or a shortage of available cash. Other times, a company is uncertain about the future, and wants to keep cash on hand to protect it against unforeseen risks or seize unexpected opportunities.

And sometimes, it’s because the company’s leadership thinks they can offer shareholders more value by investing the cash currently earmarked for dividends back into the business itself.

A Look At How Dividends Work

The reason that a company will offer a dividend in the first place is to reward shareholders. In some cases, companies pay dividends only to preferred stock shareholders, or pay a higher rate to certain classes of shareholders than others.

Most companies offer the regular cash payouts because management believes that paying a dividend is a better use of that capital than any strategic growth opportunities the company would otherwise invest in.

Companies that offer dividends are usually established businesses in mature industries, such as healthcare or utilities. They typically pay out their dividends on a regular schedule, annually, semi-annually, or even monthly.

Investors often rely on dividends, either as part of their investing strategy, or as a source of income. Dividend-paying stocks are especially popular among retirees, who use the income to help cover living expenses. Companies suspending dividends run the risk of alienating a sizable portion of their shareholders.

It’s important for investors to understand why a company in their portfolio has cut its dividend, and to use that information to determine whether that stock still makes sense for their broader investing strategy or whether it might be time to sell the stock. Sometimes when a company cuts its dividend, its stock price will also fall.


💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Examples of Dividend Cuts

History has provided many examples of companies that reduced, suspended or eliminated their dividends. We’ll start with a recent example, and cite several others from the past few years.

Intel — Dividend Reduction

In early 2023, Intel announced that it was cutting its quarterly dividend by almost two-thirds. That put the company’s dividends at their lowest levels since before the financial crisis in 2007. Intel’s leadership cited slowing business growth and an attempt to reallocate capital as the primary reasons for the dividend reduction.

Meredith Corp. — Dividend Suspension

In April of 2020, media company Meredith Corp, suspended its dividend payments. The move came just over two months after it had announced a dividend hike. The company eliminated its dividend amid widespread reductions in expenditures, including salary cuts after it had seen significant advertising cancellations and delays.

Antero Midstream — Dividend Reduction

In February of 2021, Antero Midstream reduced its dividend by 27%. The company, which builds and operates pipelines, storage facilities and other infrastructure for natural gas, and water handling and treatment, cut the dividend in order to grow.

By cutting its annual dividend from $1.23 a share to just 90 cents, Antero Midstream was able to free up an estimated $65 million to invest in new infrastructure. Unlike some other companies who eliminate or trim their dividend because of business reversals, Antero made the move in response to promising signals about growth opportunities. Even with the cut, the company maintained a 10.3% dividend.

Estee Lauder — Dividend Suspension and Reinstatement

Also in 2020, Estee Lauder announced it would suspend its dividend payments. At the time, the cosmetics giant paid an annual dividend of $1.92. The company projected that as fewer people went out socially during the pandemic at the time, they’d spend less on makeup — a projection proven correct. At the time, the company also announced other spending cuts, suspending stock buybacks and cutting executive pay by as much as 30%.

But as shops, restaurants, and bars began reopening in the first quarter of 2021, makeup sales also rose. As Estee Lauder benefited from higher sales it responded by reinstating its quarterly dividend. In May of 2021, it announced a quarterly dividend of 53 cents per share.

Healthpeak Properties — Dividend Reduction

Healthpeak Properties, a real estate investment trust (REIT) focused on properties related to life sciences, medical offices and senior housing, cut its quarterly dividend payment in February of 2021 from 37 cents per share to 30 cents per share.

At the time, Healthpeak had $1.6 billion in free cash flow. But it had concerns about the future, given the potential of recent pandemic-related mortalities to drive down demand for senior housing. Its net income in 2020, at $413.6 million, was already much lower than the $787 million it had made in dividend payouts in 2020. The dividend reduction freed up an estimated $150 million in cash flow for Healthpeak, which the company intended to use to transition its holdings away from senior housing.

National CineMedia — Dividend Reduction

During the pandemic, people stopped going to the movies. That had a major impact on theater chains, but also on companies like National CineMedia, which sells pre-screening advertising at theaters across the United States.

That’s why the company cut its quarterly dividend from seven cents to five cents per quarter in early March of 2021. At the time of the cut, the company was in solid financial shape, with enough cash to cover its expenses. But even with ample cash, the company trimmed its dividend amid concerns about how long it will take for theaters to return to pre-pandemic normals.

The Walt Disney Company — Dividend Suspension

In May of 2020, The Walt Disney Company announced it would suspend its dividend payments due to the impact of the coronavirus on its theme parks.

The dividend suspension occurred as the company’s earnings had plummeted due to the pandemic. By eliminating its semi-annual dividend, which it had kept at 88 cents a share since 2018, the company saved $1.6 billion of much-needed cash to preserve liquidity.

While Disney has not announced plans to reinstate its dividend, the company’s entry into the video-streaming business with its Disney+ service has many investors looking at the stock as less of an income investment, and more as a long-term growth play.


💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.

The Takeaway

Companies cut their dividends for many reasons, using the move as a way to preserve cash for future investments or during uncertain times. While investing in dividend stocks can be a smart way to generate income or increase returns on a portfolio, it’s important for investors to understand that dividends are not guaranteed in perpetuity and to consider changes in a company’s dividend payout as one factor in analyzing the value of that stock.

If you want to make dividends an important component in your investing strategy, you’ll need to do a good amount of research. There’s also some luck involved — you never know what might inspire companies to cut dividends.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
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Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Aug
14
2023
What Is a Backdoor Listing? Definition and How It Works

What Are Backdoor Listings? Definition and How It Works

By | Growing Wealth, invest, Investing | Comments Off on What Are Backdoor Listings? Definition and How It Works

A backdoor listing can allow a private company to become publicly traded, without having to pursue an initial public offering (IPO). This strategy can be less time- and cost-intensive for companies that are interested in being listed on a public stock exchange.

There are different ways backdoor listings can occur. A key question for investors is whether it makes sense to invest in stocks associated with a backdoor company.

What Is a Backdoor Listing?

In most cases, a company that wants to make its shares available for trade on a stock exchange would go through an initial public offering, or IPO. This process, regulated by the Securities and Exchange Commission (SEC), ensures that companies meet certain requirements before they can be listed on the Nasdaq or the New York Stock Exchange (NYSE).

A backdoor listing allows companies to list shares of stock on a public exchange while circumventing the traditional IPO process. These companies effectively go through the “back door” to get their shares listed. Some investors also call this process a reverse listing, reverse IPO, a reverse takeover or a backdoor to the trade.


💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

How Do Backdoor Listings Work?

Generally speaking, a backdoor list transaction allows companies to go public without the usual IPO requirements. There are typically three strategies private companies use to pursue a backdoor listing.

•   Reverse merger/takeover. In a reverse merger or reverse takeover, a private company purchases a majority shareholder interest in a publicly-traded company in exchange for shares in the public company. The two companies then merge, operating under the name of the publicly-traded company going forward.

•   Shell company. In some cases, the backdoor company may wish to continue doing business independently, even after completing a reverse merger or takeover. To do this, they create a shell company, that allows both the formerly private company and the publicly-traded company it acquired or merged with to continue operations.

•   SPAC. This strategy essentially combines the other two. A SPAC is a “special purpose acquisition corporation,” a shell company created specifically to purchase a private company. The SPAC goes public and then uses the proceeds from its IPO to purchase a private company.

Recommended: What You Need to Know Before Investing in SPACs

Each approach offers a shortcut to trading on a public exchange for private companies. In the case of a reverse merger, the private company would gain control of the public company’s board of directors. Depending on the terms of a backdoor listing, this can result in a restructuring or reorganization of the public company it acquired.

Backdoor Listing Example

It can be helpful to have a real-world example of a backdoor listing to better understand how they work. One high-profile instance of a backdoor listing over the last decade involved the reverse merger of T-Mobile USA with MetroPCS in 2013.

In that deal, MetroPCS declared a 1-for-2 reverse split of its stock, while paying out $1.5 billion in cash to its shareholders. T-Mobile USA assumed a 74% ownership stake in the company, a deal approved by MetroPCS shareholders. Following the reverse takeover, MetroPCS stock began trading under the symbol TMUS.

Using a more general example, Company A may wish to go public but not meet the SEC’s IPO requirements for size or valuation. Instead, it chooses to buy a majority ownership stake in its competitor, Company B, which trades on the NYSE. Following the reverse merger, Company A assumes Company B’s name and is now a publicly-traded stock.

Advantages of Backdoor Listings

Private companies may prefer a backdoor listing for several reasons, including:

•   Capital preservation. Filing an IPO involves numerous costs, including underwriting fees and SEC registration fees. This can amount to millions, or tens of millions of dollars in some cases. Choosing a backdoor IPO could yield substantial cost savings for private companies.

•   Speed. The traditional IPO timeline can take anywhere from six months to a year to complete, owing to the various steps in the process that must be completed. On the other hand, companies can complete a reverse takeover, in as little as a few weeks, allowing private companies to go public at a much faster pace.

•   Avoiding IPO valuation rules. The SEC has some strict guidelines with regard to things like how IPO valuations are set. By going through the backdoor to the trade, companies can sidestep these requirements altogether.

•   Skipping the lockup period. Early investors and employees typically can’t trade their stocks during a certain period before and after a traditional IPO. Companies that use a backdoor IPO typically don’t impose such restrictions on shareholders.

•   IPO failure. Companies may also turn to a backdoor listing if they had an unsuccessful IPO.

There can also be advantages for the original shareholders of a backdoor company. If a reverse IPO boosts the share value of the newly merged company, that can increase the value of shareholders’ equity.

Disadvantages of Backdoor Listings

Backdoor listings also pose some potential problems for the private company executing it and the publicly-traded company it acquires. Some of the key issues that may result from a backdoor listing include:

•   Share dilution. Share dilution occurs when a public company issues new shares to the market, which can sometimes happen in a reverse takeover. This may decrease the value of equity for shareholders who already own stock in the company.

•   Incompatibility. It’s also possible that a backdoor listing fails to yield sufficient benefits for both companies involved.In that case, rather than driving profits up, a reverse IPO could result in financial losses.


💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

What Do Backdoor Listings Mean for IPO Investors?

Buying IPO stocks may appeal to investors who want to get in on the ground floor of a company that’s going public. If an IPO takes off, early investors could reap significant rewards later if they’re able to sell their shares at a profit down the line.

Backdoor listings can mean fewer opportunities to invest in IPOs. They’re not, however, shut out from trading stocks upon completion of the merger. Say, for example, there’s a private company you’ve been hoping will go public. Instead of launching an IPO, the company chooses to execute a reverse takeover instead.

You may be able to capitalize on that by purchasing shares of the public company it plans to merge with ahead of a reverse IPO. Or you may wait until the dust settles on a backdoor listing to invest in the newly merged company. In either case, the opportunity to invest in the private company you had your eye on isn’t lost. It simply takes on a new form.

Recommended: SPAC IPO vs. Traditional IPO: Pros and Cons of Investing in Each

The Takeaway

Backdoor listings allow a private company to become publicly traded, without having to pursue an IPO through traditional means. There can be advantages to going public via a backdoor listing, and it may be used as a way to speed up the process or to IPO in a less expensive way.

For investors, knowing about backdoor listings can simply be another way to be privy to new company shares hitting the stock exchanges. But investing in companies that are fresh to public markets has considerable risk. It can be attractive, but investors would do well to think their investment choices through before investing. It may also be worthwhile to speak with a financial professional for advice.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

Photo credit: iStock/NeoLeo

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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14
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How to Sell Options for Premium

How to Sell Options for Premium

By | Growing Wealth, invest, Investing | Comments Off on How to Sell Options for Premium

Many investors are looking to drive returns on their options trading strategies, and selling options for premiums is one way to do that. Option premiums are a sort of fee or initial price an option holder pays in order to trade contracts, and there is room to make a profit utilizing them.

But keep in mind that options trading is an advanced investment strategy, and that it may be over your head, particularly if you’re a new or young investor. That said, options premiums do have profit potential — if you know what you’re doing.

What Is An Option Premium?

An option premium is the price an option buyer pays to purchase options contracts at a fixed rate when the contract term ends. A seller, conversely, receives the payment. In other words, it is the current market price of an option contract, and the amount the seller makes when someone purchases the contract.

When investors buy options contracts, they are purchasing a derivative instrument that gives them the right to trade the underlying asset represented by the contract at a specific price within a predetermined period of time. The premium is the amount that the option writer receives if the contract holder exercises their right to buy or sell the asset.

The premium amount depends on how much time there is left until the option contract expires, the price of the underlying asset, and how volatile or risky it is.

Recommended: How To Trade Options: A Guide for Beginners

What Is Selling Options Premium?

Many investors are familiar with the process of investing in and trading options, but the other side of the market is to be on the seller side (writing options) and make a profit by selling for a premium.

Selling options is an options trading strategy in which an investor sells a buyer the right to purchase a stock at a predetermined price at some time in the future. The premium amount is collected upfront as a payment for the options seller taking on the risk that the underlying asset will rise or fall in value within the timeframe of the contract. The premium is not refundable.

The options seller can make a profit from the premium. In addition, if the buyer doesn’t exercise their right to trade the asset, when the contract expires the seller still holds the asset as well.

However, option selling also carries some investment risk. If the option ends up “in the money” for the buyer, the option writer could lose money, since they’ll have to sell the stock for less than its market price.

How Is an Options Premium Calculated?

The main factors that affect an option contract price are implied volatility, stock price, time value, and intrinsic value. Options writers receive premiums upfront when a buyer purchases a call or a put.

When an investor looks at options contract prices, they receive a per share quote, but each contract typically represents 100 shares of underlying stock. Investors will decide to either buy call or put options, depending on how they expect the stock’s price to perform in the future.

For example, an investor could decide to purchase a call option. The seller offers it to them for a $4 premium. If the investor purchases one contract which represents 100 shares of that stock, they would pay $400 for it. If the buyer never executes the contract (because the price of the stock is at or below the strike price when the contract expires), the seller’s profit is $400, or the entire premium.


💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.

Stock Price

If an investor buys a call option, they are hoping the underlying stock price increases, whereas if they buy a put option they hope it decreases. When the stock price goes up, the call option premium goes up and the put option premium goes down. And vice versa.

Recommended: What Makes Stock Prices Go Up or Down?

Time Value

Time value reflects the expiration date of the option contract. If the option has a longer time left until its expiration date, it has more time to pass the strike price. That makes it more valuable because it gives the investor more time to exercise their right to trade for a profit. The decrease in time value over time is called time decay.

The closer the option gets to expiring, the more the time decay increases. The value of the options contract declines over time due to time decay, which is a risk investors should consider. Options buyers want the stock to quickly move up and down so that the time decay doesn’t affect their profits, whereas options sellers want the premium to decrease, which happens with every day that goes by.

Time value is calculated by subtracting intrinsic value from the premium.

Intrinsic Value

The intrinsic value of options is the difference between the current underlying stock price and the option’s strike price. This difference is referred to as the “moneyness” of the option, where the intrinsic value of the option is how far in the money the option is.

If the price of the underlying asset is higher than the option strike price, a call option is in the money, making it worth more and priced higher. If the stock price is lower than the option contract strike price, this makes a put option in the money and worth more. If an option is out of the money it has no intrinsic value.

Implied Volatility

High premium options often reflect securities with higher volatility. If there is a high level of implied volatility, this means there is a prediction that the underlying asset will have bigger price moves in the future, making the option more expensive.

A low level of implied volatility will make it cheaper. It’s best for investors to purchase options that have steady or increasing volatility, because this can lead to bigger profits and a higher likelihood that the option will reach the investor’s desired price. Those who are selling options prefer to have decreasing volatility, because this lowers the premium and allows them to buy back the option at a lower price.

Other Factors

Other factors that influence premium prices include:

•   Current interest rates

•   Overall market conditions

•   The quality of the underlying asset

•   Any dividend rate associated with the underlying asset

•   The supply and demand for options associated with the underlying asset

Options Premiums and the Greeks

Certain Greek words are associated with types of risks involved in options trading. Investors can look at each type of risk to figure out which options they want to buy.

•   Delta: The sensitivity of an option price to changes in the underlying market

•   Gamma: The amount that an option’s delta moves with each point of movement of the underlying market asset

•   Theta: That amount that an option price decays over time

•   Vega: The amount that underlying market volatility affects the option

•   Rho: The amount that interest rate changes affect the option price


💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.

The Takeaway

Options are one type of derivatives that give the buyer the right, but not the obligation, to buy or sell an asset. To sell options for a premium, options writers must consider several factors that could determine the future price of that asset. Selling options for premium is potentially a profitable trading strategy.

Note, though, that trading options is risky and advanced. It can be a confusing, muddled section of the financial markets, and it can be very easy for investors to get in over their heads. If you’re interested in trading options, it may be best to speak with a financial professional first.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

Photo credit: iStock/sefa ozel

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Aug
14
2023
What Are Discount Brokers? What to Look For in a Broker

What Are Discount Brokers? What to Look for in a Broker

By | Growing Wealth, invest, Investing | Comments Off on What Are Discount Brokers? What to Look for in a Broker

Discount brokers make it possible for investors to buy and sell securities, without paying the higher fees associated with a full-service brokerage. Using a discount brokerage could make sense for investors who are comfortable making trading decisions without the help of an investment professional.

The rise of discount brokerage firms has made investing more accessible for a wider variety of people. Discount stockbrokers can offer both tax-advantaged and taxable investment accounts. It’s possible to build a portfolio with a discount broker that includes different types of investments, including stocks, exchange-traded funds (ETFs) and other securities.

What Is a Discount Broker?

Discount brokers offer investors access to lower-cost securities trading. Many discount brokerage firms operate online or via mobile investment apps. They’re often geared to the DIY investor who’s interested in self-directed trading.

Some of the characteristics of discount brokers can include:

•   Investment selection that can include stocks, ETFs, mutual funds, bonds

•   Low or zero commission fees to trade stocks and exchange-traded funds (ETFs)

•   Fractional share trading

•   Low minimum investment thresholds

•   Investor-guided trading

While discount brokers offer a flexible way to invest they’re still subject to government regulation. Discount brokerage firms must register with the Securities and Exchange Commission (SEC). They must also belong to the Financial Industry Regulatory Authority (FINRA) and the Securities Investor Protection Corp (SIPC).


💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

History of Discount Brokers

Discount brokerages have grown in popularity in recent years but online trading has its roots in the 1980s.

In 1984, Charles Schwab introduced The Equalizer, the first DOS-based portfolio management and trading tool. Shortly after, competitors entered the market, including TeleBroker, the first phone-based keypad trading application, and StreetSmart, a PC-based trading software program.

In 1992, E-Trade became the first online brokerage service provider. By 1995, E-Trade generated 80% of its revenues from trading commissions and the number of new discount brokerages joining the fray continued to grow. Larger firms, such as Charles Schwab and Fidelity began offering discount broker services. Over the last decade or so, they’ve been joined by newer startups.

Along with the introduction of new online trading platforms and expanded investment options, the discount broker industry has evolved from a pricing perspective. Many, if not most brokerages now offer commission-free trades, for instance.

How Do Discount Brokerages Work?

Discount stock brokerages put the investor in the driver’s seat. You decide which type of account to open with a discount broker. This may be a tax-advantaged account, such as a traditional or Roth Individual Retirement Account (IRA). Or you may choose to open a taxable brokerage account instead.

Once you open your account, you can then decide how to allocate it and how much to invest.

Recommended: Active vs Passive Investing: What You Should Know

With a discount brokerage, you decide how much to invest in each fund or stock. You also have control over how long you hold those investments and when you decide to sell. When you’re ready to execute trades, you may pay low or no commission fees to do so.

Discount brokerages can also open the door to new investment opportunities, beyond stocks or ETFs. For instance, you may be interested in investing in IPO stocks. With a discount brokerage account, you may have tools on hand to help you understand how the IPO process works and how companies set an IPO price. You can then compare IPOs and decide whether you want to invest, based on your investment goals and risk tolerance.

Discount brokers work well for newer investors and more advanced investors alike. They’re not as well suited for venture capitalists or investors with large portfolios who might be interested in crowdfunding options for investing or investors who want access to things like hedge funds and private equity.

Full-Service Brokers vs Discount Brokers: Key Differences

Brokerage firms help investors to execute trades of stocks and other securities. There are two main types of brokers to choose from: full-service and discount brokers.

Full-service Brokerages

Full-service brokerages assist clients with making trades. But they can also provide other services, including offering investment advice. For instance, a broker might recommend specific stocks or mutual funds to invest in. In exchange for this advice, investors pay fees on top of the commissions they may pay to complete trades.

Discount Brokerages

A discount brokerage differs in the scope of services provided and the fees investors pay. With discount stockbrokers, investors receive little to no direct personalized financial advice or analysis from investment professionals. Instead, it’s up to the investor to decide which securities to buy or sell.

Discount brokerage firms are effectively a link between investors and the market, as they help to carry out trade transactions. But they don’t have the higher fees associated with full-service brokerage firms.

Pros and Cons of Working With a Discount Stock Broker

Choosing a discount broker in place of a full-service broker can offer both advantages and disadvantages. While full-service brokers have a longer track record, discount brokers are making it easier for a broader group of investors to gain entry to the market.

Whether using a discount broker makes sense depends on what you need from a brokerage and what you’re willing or able to pay to build a portfolio. Here’s an overview of the main pros and cons to consider when comparing discount stockbrokers against a full-service option.

Pros of Using a Discount Broker

•   Cost. Arguably, the best reason to consider discount brokers in lieu of full-service brokers is cost. Discount brokers charge lower commission fees to trade, and you’re not paying additional costs for their professional investment research or advice since you’re responsible for making investment decisions.

•   Convenience. Discount stock brokerages make it easy to invest from virtually anywhere, since you can execute trades online or via mobile apps. If you come across a buying opportunity, for example, you can log in and complete the transaction in minutes without having to connect with a human broker first.

•   Variety. Another advantage of using a discount stock broker is the selection of investments to which you have access. That may include not only stocks, mutual funds, ETFs and bonds but you may also be able to buy IPO stock, commodities, or options. Discount brokers make it easier to build a diversified portfolio in one place, with minimal costs.

•   Self-directed trading. If you prefer making investment decisions yourself, a discount brokerage account allows you to do so. You can choose when to buy or sell and how much of your portfolio to allocate to one security versus another.

Cons of Using a Discount Broker

•   No access to professional advice. While discount stockbrokers can be cost-friendly, they’re typically missing one big thing: professional advisors to guide you through the investment process and discuss potential investment risks. Whether this is a con for you depends on how comfortable you are charting your own course with investing.

•   Customer support. Every discount brokerage is different in terms of the level of customer service and support they provide. Some may be more helpful than others, which is something to consider when choosing a discount broker.

•   Not fee-free. While many discount brokers charge $0 commissions to trade U.S. stocks and ETFs, that doesn’t mean there are no fees for trading. You may pay fees to trade mutual funds, for example. Or the brokerage may charge an extra fee if you need to complete a trade by phone.

•   Some limits: While discount brokerages give investors access to many types of investments, they don’t typically offer access to some riskier investments, such as hedge funds or crowdfunding.

What to Look for When Choosing a Discount Brokerage to Work With

If you’re interested in opening a brokerage account, researching your options is the first step. While picking the right brokerage won’t guarantee returns, it can make it easier for you to manage your portfolio and focus on your investments. When comparing discount brokers, here are some of the most important things to keep in mind.

•   Cost. First, consider what you’ll pay to trade stocks and other securities at a particular brokerage. Also, be sure to check the full fee schedule to see what additional trading or account fees may apply.

•   Investment selection. Next, consider what investments you can add to your portfolio with a particular discount stock broker. Some discount brokers may not offer certain options.

•   Minimum investment. Depending on where you are on your investing journey, you may have a lot of money or a little to start trading. So consider the minimum investment required to open an account at different discount brokerage firms.

•   User experience. If you’re going to be making trades online or via a mobile device, it’s important that the platform you use be easy to navigate. Check out websites and mobile apps for different discount brokers to see how they compare in terms of features and ease of use.

•   Research tools. Discount stock brokerages may offer research and analysis tools to help you construct your portfolio. Consider what types of tools, (i.e. tickers, stock simulators, etc.) may be available to help with your investment decision-making.

•   Customer support. Look at what type of customer support is available to help investors with a particular discount broker. The more ways you can communicate, such as email, by phone or live chat, the easier it may be to get help managing your account when you need it.

•   Reputation. Finally, consider how well a discount broker stands out compared to the competition. Does it have a great reputation for low-cost trading, for example? Has it won any major industry awards? What are investors saying about the brokerage? Looking at a discount stockbroker’s overall reputation and track record can help decide if it’s a good fit.



💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Discount Brokers Make Investing Affordable

Opening an account with a discount broker can be a first step toward growing wealth. Because they’re generally a low-cost way to invest, you’re able to preserve more of your investment returns over time. These days, most brokers have had to adjust to account for discount brokers in the market, which is generally a good thing for investors.

But remember that discount brokers have their pros and cons, and that investors would do well to do some research before picking a broker. Each broker won’t be the right fit for each investor, so again, take the time to look into potential options before taking the plunge.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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